Choosing an investment style

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The question that is often asked by investors is, “What types of stocks
should I buy?” Should you rush to buy the small-cap growth stocks
that have outperformed large-cap growth stocks or should you look
for value stocks? The question relates not only to the investment type
but also to the size of the company stocks. Some investors feel comfortable
going after the winning categories, whereas the more patient
investor is content to invest in the lagging categories, which will rise
over time.

Studies have shown that stocks can be classified into categories
that have similar patterns of performance and characteristics. In
other words, the returns of the stocks within the categories were
similar, whereas the returns of the stocks between the categories
were not correlated (Farrell, 1975, pp. 50–62). Farrell found four categories
for stocks, namely, growth, cyclical, stable, and energy. Other
studies measured stocks by their market capitalization or size, which
was then translated into small-cap, mid-cap, and large-cap stocks.
What portfolio managers found was that they could enhance their
performance by moving their money into the different categories of
stocks from time to time.

From these categories of stocks, two investment styles have
emerged, namely, value and growth investing. Figure 13–1 illustrates
the common styles of equity investing as developed by
Morningstar Mutual Funds for mutual fund investing, but they
also can be used to determine individual equity portfolio holdings.

Investors can use this style box to determine if the bulk of their
equity investments suits their investment style, as determined by
their investment objectives. Value stocks have different financial
characteristics and returns than growth stocks. Value stocks generally
have low P/E ratios that are less than their expected growth
rates. Growth stocks generally have high P/E ratios and are expected
to experience high sales growth for a period of time. Ablend includes
a mixture of growth and value stocks. The size of the company is
measured by market capitalization, which is the market value of
its stock multiplied by the number of shares outstanding. Small-cap
companies are riskier than mid-cap or large-cap companies, but as
the Ibbotson study showed, the returns over longer periods for smallcap
stocks generally have exceeded the returns of large-cap stocks.
Small-cap value stocks have outperformed large-cap growth stocks
quite handily over the 21⁄2-year period 2003–2005. Consequently,
stock picking becomes extremely important for individual portfolios,
particularly when the investment style is to time the markets.

The style box in Figure 13–1 illustrates the choices in terms of
investment styles and sizes of companies. Investors can choose the
current winners (2006), which happen to be small-cap value stocks,
in which to invest more money. Alternatively, some investors
might not want to pay high prices for these types of stocks and
instead would look for the quadrants of stocks that have not participated
in the recent rally (large-cap growth stocks, for example).
Some investors might want to have a combination of growth and
value stocks in the different size categories. This style box also can
be used with international stocks.

Research has shown that value and growth stocks do not perform
in the same manner within the same time periods. This is
evidenced recently by the spectacular performance of large-cap
growth stocks in the late 1990s, during which time large-, mid-,
and small-cap value stocks underperformed the market. Since 2000,
small-cap value stocks have outperformed large-cap growth stocks.
One investment style (growth versus value) is dominant at a given
point in time. Some investors choose to invest all their funds in the
stocks that are performing well and then shift to other investment
styles when they perceive that things are about to change. This style
of investing would be more conducive to an active management
style, as opposed to a passive management style, where investors
would allocate their stocks among the different categories and then
hold them for long periods. Active managers are more likely to be
market timers and are more inclined to be fully invested in stocks
when they perceive the market to be going up. The opposite occurs
when they think that the market is about to decline; they exit the
market. Passive investors tend to stay fully invested in stocks
irrespective of the state of the markets.

Investors need to decide ultimately whether they choose value
or growth stocks and whether they will be active or passive managers
of their portfolios. The selection of individual stocks can be
made easier if direction is provided through an asset allocation
model, which breaks down the different style categories of investment
by the asset class. Table 13–1 lists a few examples of the different
portfolio possibilities. Investors might invest in a mixture of
value and growth stocks, which could be allocated among domestic
U.S. stocks and international stocks. Investors then would decide on
the amounts to allocate to the different stock sizes, large-, mid-, and
small-cap (Example 1 in Table 13–1).

Example 2 illustrates a value stock portfolio and Example 3 a
growth stock portfolio. Diversification within the stock sector of an
investor’s portfolio offers protection against the downside risk of
being fully invested in only one sector, such as large-cap value or
growth stocks, for example. If the tide turns against stocks in one
sector, investors would be protected by being able to participate in
any price improvement in other sectors should the stock market
rally become more broad-based.